Journal of Financial Planning: January 2015
Tom Lydon is editor of ETFtrends.com, president of Global Trends Investments, a registered investment adviser. He is a frequent contributor to major print, radio, and television media.
Though slightly more volatile due to their association with developing economies, emerging market bond ETFs can help enhance yield generation for a fixed-income portfolio and diversify exposure into potentially under-allocated foreign markets.
Emerging market issuers have shown they can grow at a faster rate and potentially issue a greater source of income in low-yield environments as developing economies are supported by better demographics, fiscal solvency, and monetary flexibility. Emerging countries have large pools of young workers and a rising middle class. Many developing economies have also maintained healthier finances, with most emerging markets’ debt-to-GDP ratios below 60 percent. Developed economies have higher debt-to-GDP ratios.
Many emerging market sovereign and corporate debt securities have investment-grade credit ratings. Nonetheless, emerging market debt isn’t without risks. Risks are tied to developing country debt, including sensitivity to sudden swings in volatility or dips in investor risk appetite. Emerging market debt is vulnerable to inflationary pressures, but many emerging central banks and governments adhere to stringent policies to monitor inflation. Local debt securities are tied to their local currencies, so there is some level of currency risk—an appreciating emerging market currency would boost the bond’s U.S.-dollar-denominated returns, whereas a depreciating local currency would weigh on returns.
For instance, the Market Vectors Emerging Markets Local Currency Bond ETF (EMLC) and WisdomTree Emerging Markets Local Debt Fund (ELD) both track a basket of emerging market government bond securities denominated in their respective local currencies, so be aware a level of currency risk when investing in these products.
EMLC has a 0.47 percent expense ratio, a 3.63 percent 30-day SEC yield, and a 4.60-year duration. ELD has a 0.55 percent expense ratio, a 5.23 percent 30-day SEC yield, and a 5.16-year duration.
Like most ETFs, no two products are the same. The iShares J.P. Morgan USD Emerging Markets Bond ETF (EMB) and the PowerShares Emerging Markets Sovereign Debt Portfolio (PCY) both track U.S. dollar-denominated government debt securities issued by emerging market countries. These types of bond securities would act better when the U.S. dollar is appreciating or emerging markets are depreciating.
EMB has a 0.60 percent expense ratio, a 4.61 percent 30-day SEC yield, and a 7.15-year duration. PCY has a 0.50 percent expense ratio, a 4.89 percent 30-day SEC yield, and a 9.1-year duration.
Both EMB and PCY track a larger group of emerging market issuers and take a diversified approach to country allocations—their largest country weights at around 5 percent.
When comparing the local currency and USD-denominated debt securities, the local currency debt funds tend to carry higher credit ratings relative to the USD-currency bonds.
EMLC and ELD carry greater tilts toward higher-quality bonds. EMLC includes 4.0 percent AAA-rated debt, 3.4 percent AA, 19.3 percent A, and 38.1 percent BBB. ELD includes 4.7 percent AAA, 10.5 percent AA, 44.6 percent A, and 28.6 percent BBB. In contrast, EMB holds 4.7 percent AA, 16 percent A, and 45.8 percent BBB, while PCY has 0.8 percent AAA, 4.5 percent AA, 16.9 percent A, and 48.1 percent BBB.
Advisers can further customize their exposure through bond ETFs specifically targeting emerging market corporate debt, like the WisdomTree Emerging Markets Corporate Bond Fund (EMCB) or iShares Emerging Markets Corporate Bond ETF (CEMB).
EMCB and CEMB track a basket of USD-denominated corporate bonds issued by emerging countries, and both include exposure to Brazil, Mexico, and Russia. They track investment-quality debt securities but neither includes AAA-rated bonds.
Most investment portfolios largely focus on U.S. assets, but advisers can diversify their fixed-income exposure with emerging debt and access relatively attractive yields.